As a small-business owner you will be spending a significant amount of time trying to increase your business’s profitability. You may not succeed in increasing profitability all the time, no matter how hard you try.
Let us get down to the “science” of increasing your business’s profitability. There are only 3 ways of doing it.
(1) Decrease expenses
(2) Increase margins
(3) Increase sales
You can do all three at the same time - that is, if luck and the time you have to devote to the task are on your side. However, our advice would be to pick the easiest avenue first (decreasing expenses). Then proceed to the second easiest (increasing margins) and then, finally, to the toughest (increasing sales).
In the sections that follow, we explain what you need to know about each of these three options.
Decreasing (or controlling) expenses
The biggest advantage that comes from trimming expenses is that you’ll have a direct short-term impact on the bottom line. For every Rupee you save by eliminating an expense, you earn an extra Rupee of profit.
Of course, not all expense cutting is equal. Operating a lean business is fine but you must be thoughtful about where and how you reduce your expenses. You need to consider all the effects of cost cutting - not just the short- term, bottom-line effects - before you make any cuts.
Controlling expenses is a cultural issue, which means that it’s a lead-by-example issue that begins with you. From the day you open your business’s doors, you must pay close attention to managing its expenses, being careful not to spend money carelessly and being tactfully critical of those who do. If the boss sets the right example, the rest of the company is certain to follow.
The following sections give you guidelines for successfully controlling expenses.
Zero-based budgeting
After you determine what kind of expense-controlling culture you want to set up in your business, your next step is to a zero-based budgeting program. Zero-based budgeting requires that you begin each year’s annual budget process by setting each expense category to zero. In other words, you question every Rupee that went into that expense account - hence, the term zero-based.
Most businesses add a percentage increase to the preceding year’s expenses, with the rate of the prior year’s inflation increase being the most frequently used common multiplier. It’s quick and easy but it carries last year’s fat into this year’s menu. Ditto with next year’s menu, and so on, forever - unless that particular expense category is eventually purged through the zero-based budgeting technique.
Here’s an example of how zero-based budgeting works: Suppose it’s time to budget your telephone expense for the year. The zero-based budgeter’s job is to examine and evaluate the company’s telephone needs - to determine what kinds of calls need to be made in the course of business and then collect quotes from alternative carriers and indicate the budgeted figure in budget.
Trimming costs
In addition to zero-based budgeting, effective control of expenses requires understanding the 80-20 rule as it applies to expenses. The 80-20 rule maintains that you can usually find 80 percent of wasted expense Rupees in 20 percent of the expense categories.
As you create your budget, challenge expenses in all categories, large and small. You can usually find quick-and-easy Rupees to save by rooting around in such overlooked expense categories as utilities, travel and entertainment, insurance, and the compost heap of them all, the miscellaneous category.
The following tips provide a framework in which you can effectively control your expenses:
Avoid overstaffing. Finding and hiring a employee is costly, and after you’ve hired one, releasing her is not only difficult but also expensive. Use outside contractors, temporary services, and part-timers if you’re on the fence about the need to hire a full-time employee.
Automate where possible. Technology is usually cheaper than people (and it can be depreciated). When possible and when doing so won’t compromise the quality of your products or services, purchase software in lieu of hiring additional employees. Functions such as accounting, inventory control, accounts receivable, and payroll lend themselves to automation.
Put the responsibility for controlling expenses to employees. It is where it belongs - in the hands of the employees who spend the money. Also, make them accountable for their actions. Reward them when they meet their goals and provide corrective feedback when they don’t. Ask for price quotes before you obligate yourself to services. This is true for everything from lawyers, accountants, and financial advisors to computer repair people, plumbers, and consultants. Also, make sure that you always ask for itemized invoices.
Remember that effective expense control isn’t a one-time event; it’s an ongoing occurrence whose success or failure lies entirely in your hands.
Increasing margins
Here’s a simple illustration of how to understand what the margin is on a given transaction: If your product sells for Rs. 1500 and the cost of that (including shipping charges) is Rs. 1000, your margin is 33.33 percent.
You can increase margins in three ways: By raising prices; By lowering the cost of the goods or services sold; By doing both. Regardless, the magic of increasing margins is that, similar to decreasing expenses, every Rupee of income derived from the margin increase ends up as additional profit, assuming no reduction in sales.
Continuing with the preceding example, if you raise the price of the product from Rs. 1500 to Rs.1600, the margin jumps from 33.33 percent to 37.5 percent, and the margin Rupees increase from Rs. 500 to Rs. 600. Because increasing prices generally costs very little, nearly the entire Rs. 100 of the price increases will be realized as profit, again assuming no reduction in purchasing from customers.
Increasing margins by lowering the cost of goods or services sold is a little more difficult. If you’re a manufacturer, you must decrease the cost of manufacturing either by cutting your labour costs or by reducing the cost of the raw materials you purchase from vendors. If you’re a wholesaler or retailer, you must reduce the cost of the goods you purchase for resale. Similar to reducing prices, this method of increasing margins also results in a Rupee-on-the-Rupee recapture of profitability.
Consider the case of the small business that does Rs. 5,000,000 in sales in a year. If the owner, at the beginning of the year, decides to increase the prices of his products by an average of 1 percent, that would mean an additional Rs. 50,000 in profits at the end of the year. An average increase of 2 percent would add Rs. 100,000 (again, all this assumes that the price increases don’t reduce sales).
Generally speaking, small-business owners are more reluctant to raise prices than they should be. The tolerance of your customers to accept price increases depends on such issues as competition, alternative and, most of all, the customer relationships you maintain.
We strongly recommend that every small-business owner review the margins on every product or service at least once a year. Determine a time of the year when raising prices makes the most sense (usually at the beginning of the business’s fiscal year), mark that date on your calendar in permanent ink, and when the time comes, start with your lowest-priced item and work up.
Don’t simply increase prices by using an across-the-board percentage increase. Also, be sure to aim for higher margins on the lower-priced items and on those products that don’t need to be as competitively priced.
But realize that you don’t have to wait until the end (or the beginning) of the year to consider increasing your prices. You may want to consider a price increase when the demand for your product suddenly increases. Perhaps a competitor has raised its prices, or perhaps the law of supply and demand is hard at work - in other words, maybe more demand than supply for the in question can provide a perfect scenario for raising prices. Don’t feel guilty for taking advantage of such situations.
Increasing sales
After you have decreased (or controlled) your expenses and increased your margins, you can focus on doing what every entrepreneur worth his weight in loan guarantees loves to do: increase sales. After all, increasing sales is what most small-business owners are born to do, and besides, offense (increasing sales) is always more enjoyable than defence (cutting expenses). Everyone loves to roll out a new product, hire a new salesperson, or develop a new sales promotion.
What’s more, you can easily measure the results of a plan to increase sales. In most cases, the act of increasing sales adds profits to your bottom line, assuming that those sales are priced at a high enough level to make them profitable. We stress the word most here because small-business owners too often attempt to solve their profitability problems by focusing only on increasing sales.
What they fail to realize is that if their sales aren’t at a price high enough to generate a profit, then adding more sales will only serve to increase their cumulative losses. Or stated another way, sales alone don’t beget profitability; only profitable sales do.
(Lionel Wijesiri is a retired company director with over 30 years’ experience in senior business management. Presently he is a business consultant, freelance newspaper columnist and a writer. He could be contacted on lawije@gmail.com)
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